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THE RATIONALE for MULTILATERAL LENDING a CRITICAL ASSESSMENT Yilmaz Akyüz1

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THE RATIONALE for MULTILATERAL LENDING a CRITICAL ASSESSMENT Yilmaz Akyüz1 Draft for discussion 5 July 2004 THE RATIONALE FOR MULTILATERAL LENDING A CRITICAL ASSESSMENT Yilmaz Akyüz1 I. Capital market failures and multilateral lending Multilateral lending has been a central element in international economic cooperation since the establishment of the Bretton Woods Institutions (BWIs) towards the end of the Second World War. These institutions in general and their lending activities in particular were designed to address specific challenges confronting the architects of the postwar international economic order. These included the need, on the one hand, to avoid the repetition of the difficulties that traumatised the world economy during interwar years, and on the other hand, to repair the damages inflicted by the war on the productive capacity and living standards of the countries involved. Accordingly, two distinct objectives were attached to multilateral lending: restoration and maintenance of international economic stability, and reconstruction and development. The world economic and political landscape has undergone significant changes since the Bretton Woods Conference (BWC), including the end of colonialism, the rise 1 Second holder of the Tun Ismail Ali Chair in Monetary and Financial Economics, University of Malaya, Kuala Lumpur; and former Director of Division on Globalization and Development Strategies, and Chief Economist, UNCTAD. Paper prepared for the UNDP Project “Public Finance in a Globalizing World”. I am grateful to Richard Kozul-Wright, Jan Kregel, Inge Kaul, Ron Mendoza and two anonymous reviewers for comments and suggestions. None of the persons mentioned are, of course, responsible for any errors or omissions. 2 and the fall of communism, closer global economic integration, and a rapid development of international financial markets. The BWIs have responded to these changes by realigning their activities both in multilateral lending and policy surveillance, though often in an ad hoc manner. Consequently, the objectives pursued by these institutions and the modalities of their operation are now significantly different from their original design. Simultaneously, there has been an intense debate over the role of the BWIs and the need for multilateral lending. It has been increasingly suggested that multilateral lending has lost much of its rationale as a result of the rapid development of international capital markets and increased access of developing countries to external private financing (see, e.g. Walters 1994; Meltzer Commission 2000). This view has found support particularly among those who subscribe to the neo-liberal view and see multilateral lending as unnecessary and even harmful intervention with the efficient functioning of international capital markets, emphasizing that governments fail more often than markets in supporting stability and growth. Ironically, these institutions, notably the World Bank, now appear to be disarmed, as lenders, by their own logic, since this neo-liberal view constitutes the intellectual basis of the so-called Washington Consensus promoted by the very same institutions. Multilateral lending is a form of global collective action designed to provide external financing to countries in pursuit of certain agreed objectives. The economic literature has established that collective action, rather than private action, would be desirable under two sets of circumstances. First, when markets fail to generate efficient outcomes due to reasons such as the presence of externalities, public goods, imperfect and asymmetric information, monopolies or imperfect competition, and incomplete markets. This is the Pareto efficiency argument wherein there is scope to improve the 3 conditions of some without worsening those of the others. Second, when there is a broad agreement on certain social and humanitarian objectives that cannot be guaranteed even under efficient outcomes. Collective action may be required for both efficiency and humanitarian reasons since “there are certain market failures which not only lead to inefficiencies (Pareto inefficient outcomes) but the incidence of those inefficiencies bears disproportionately on the poor” (Stiglitz 2003, p. 2). The main reason why the international community should be concerned with the provision of external finance to countries rather than leaving it to international capital markets is that these markets fail to fulfil this task adequately and this failure has ramifications not only for the countries concerned but also for the international community as a whole because of existence of international externalities and global public goods.2 International externalities operate through various channels. When a country facing a tightened payments constraint as a result of trade shocks or increases in international interest rates is forced to cut imports, its trading partners would also suffer because of reductions in their exports and economic activity. Again liquidity crises in debtor countries could create problems for their international creditors, threatening to destabilize international financial markets. Similarly, environmental, health and security problems associated with widespread poverty in poorer countries tend to generate negative externalities for the international community as a whole, necessitating provision of development finance to address the root causes of these problems in the countries concerned. 2 For an earlier discussion of “externalities and international public goods ... in the economic interactions of nations” see Bryant (1980, pp. 473). 4 The increased significance of international externalities associated with growing interdependence among countries, and in particular the problems posed by repeated bouts of financial crisis in developing countries, have been important factors in the increased attention paid to global public goods in the recent debate on global governance and collective action (Kaul, Grunberg and Stern 1999; and Phillips and Higgott 1999). What exactly constitutes global public goods seems to be highly contentious. However, the spectrum has been widening given the tendency of economics to invade and colonize other areas of social science, extending the notion of public goods into spheres traditionally dealt with by political scientists and sociologists (Kindleberger 1986, p. 1). Indeed, global security, global economic stability, global environment, knowledge, humanitarian assistance and global health have been included among global public goods in recent discussions (Kaul, Grunberg and Stern 1999; Stiglitz 2002a). The pursuit of global humanitarian objectives and the provision of global public goods often require provision of finance to poor countries in the form of grants or highly concessional loans and technical assistance rather than multilateral lending of the kind that could be provided by capital markets. In this case global benefits attached to redistribution from richer to poorer countries rather than international capital market failures would constitute the rationale for multilateral financing (Gilbert, Powell and Vines 1999, p. 607). By contrast, the rationale for non-concessional multilateral lending should be sought primarily in international capital market failures, even though distributional considerations also come into play in such lending since it often contains a certain element of subsidy. A major reason why rational behaviour in unfettered private capital markets give rise to inefficient outcomes is the presence of imperfect and asymmetric information (the borrower knows more about his investment than the lender, and information costs about 5 borrowers’ riskiness are high) and incomplete contracts (lenders cannot control all aspects of the borrower’s behaviour). These problems imply that lenders are generally unable to assess the quality of a loan and defaults are costly. On the other hand, as loan rates are raised to cover risks, the average quality of loans will fall because of adverse selection (lending to high-risk borrowers willing to pay high interest rates) and moral hazard (inducing “good” borrowers to invest in riskier projects). As a result, the expected rate of return net of default will decline once the loan rate has reached a certain level. Beyond that level, the lender would be inclined to ration the borrowers rather than push up the loans rates until the market is cleared. In other words, credit rationing would be an equilibrium outcome of rational behaviour of lenders under conditions of imperfect and asymmetric information and incomplete contracts.3 Clearly, the problems of information and incomplete contracts are more acute for international lending to both public and private sectors in developing countries which lack sophisticated financial institutions and markets, and effective disclosure requirements, accounting standards and prudential regulations. These lead to the overestimation of risk, increases in risk premia and loan rates, shortening of maturities, and severe credit rationing. Multilateral lending could thus rectify such capital market failures by extending long-term loans at below-market rates, including to countries which have little or no access to international capital markets. Moreover, to the extent that multilateral financial institutions (MFIs) have access to better information than private lenders and are able to exert more effective control over the behaviour of borrowers, such lending would not necessarily be associated with higher risk of default. The second manifestation of capital market failure is instability
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